IRAs

An Individual Retirement Account or Annuity (IRA) allows individual workers and their spouses to set aside funds for retirement on a tax-deferred basis. The popularity of these arrangements (and the revenue loss to the government) prompted the federal government to restrict considerably those who could deduct their IRA contributions.

Anyone with earned income (and certain spouses of workers) can open an IRA and accumulate tax-deferred earnings. However, the only workers eligible to take a full IRA federal income tax deduction without regard to their adjusted gross income (AGI) level are those who are not active participants in:

Owners cannot transfer or assign their IRAs. Distributions from the IRA must be made to the IRA owner or a named beneficiary.

There are two types of IRAs—the traditional IRA (just described) and the Roth IRA. In a Roth IRA, eligible individuals make nondeductible contributions, earnings grow income tax free, and distributions are also income tax free when certain requirements are met.

[Coverdell education savings accounts, formerly known as education IRAs, bear certain similarities to IRAs and are discussed elsewhere in this service. Click here if you want to jump to that discussion.]

The Purpose of IRAs

(1) IRAs provide retirement benefits to workers and spouses who may not be covered by another plan.

(2) The tax-deferral of IRA earnings and the tax deduction for contributions (if available) give the IRA owner an opportunity to conserve dollars that would otherwise be lost to current taxes.

(3) The IRA owner has more dollars at work than if the IRA was depleted by annual taxes on investment earnings.

Accounts vs. Annuities

Individual retirement accounts are the most popular IRA arrangement. These accounts are established with an individual retirement account document which takes the form of a trust or custodial account. The trustee or custodian of one of these accounts must be a bank, a federally insured credit union, a savings and loan association, or a person or organization that receives IRS permission to act as trustee or custodian.

Individual retirement annuities are similar to individual retirement accounts except that some unique rules apply to accommodate the special features inherent in annuity contracts.

IRA annuities may not require fixed premiums. Annual fees can be charged, and level premiums for supplementary benefits, such as waiver of premium in the case of disability, are allowed. If interest paid exceeds the guaranteed rate, a refund of premium is allowed; however, these premiums must be used to pay future premiums or buy additional benefits in a timely manner.

Contributions to Traditional IRAs

Anyone under age 70½ who receives compensation—salary, self-employment income, commissions or alimony—or is married to someone who receives compensation and files jointly is eligible to make a contribution to an IRA.

Grace Period

Eligible individuals may make IRA contributions up until the due date for filing the federal income tax return. For example, an individual could make an IRA contribution on April 15, 2016 that would be effective for tax year 2015. The time for making an IRA contribution cannot be extended past this filing date by asking for an extension.

Note that an IRA is allowed to accept deposits of tax refunds. The Treasury Department has developed an appropriate form to facilitate this transaction.

Individual Workers

Annual contributions to a Traditional IRA, a Roth IRA, or a combination of the two are limited to the lesser of 100% of earned income or a dollar amount that changes periodically. For IRA purposes, compensation includes earnings from wages, salaries, commissions, tips, professional fees, bonuses and any other earnings a taxpayer receives for providing personal services, along with taxable alimony and separate-maintenance payments. In addition, nontaxable combat pay and military differential pay are wages for IRA purposes. Military differential payments are payments an employer makes to employees who have been called to active duty for a period of more than 30 days.

Compensation does NOT include income derived from investments, retirement income, disability payments, or nonqualified deferred compensation. For example, a person who has only investment income may not contribute to an IRA.

Taxpayers who have reached at least age 50 by December 31 of a year are permitted to make additional "catch-up" contributions to IRAs. The limits are summarized in the following schedule:

Spousal IRAs

A working spouse may set up and contribute to an IRA for a non-working (or part-time) spouse, based on the earnings of the working spouse. The non-working spouse's IRA is often called a "spousal IRA." The spousal IRA deduction is $5,500 in 2016 when one spouse has compensation or earnings of less than $5,500 for the year ($6,500 for age 50 and over). However, the combined annual IRA contributions of both spouses cannot exceed their combined compensation for the year.

The annual limit on spousal IRA contributions rises with the general increase in IRA contribution limits.

Excess Contributions

Contributions that exceed the allowable limits may be refunded without penalty within a limited period of time—generally before the tax return for the year is required to be filed, including extensions. If the excess remains in the IRA beyond this grace period, it is subject to a 6% annual excise tax until withdrawn. The interest attributable to excess contributions may also avoid the 6% penalty if refunded before the tax filing due date. This interest is taxable, and, if the taxpayer is under age 59½, is subject to the 10% penalty for premature distributions (unless an exception applies).

Deductions for Contributions to Traditional IRAs

Non-active Participants

Contributions to traditional IRAs are fully deductible up to the current year's contribution limit when neither the taxpayer nor the taxpayer's spouse is an active participant in an employer's qualified retirement plan.

Active Participants

The IRS defines an active participant as a person covered by a plan for a tax year. A person is considered covered by a defined contribution plan (money purchase pension, profit sharing, 40l(k) plans, stock bonus plans, SEPs, SIMPLE and 403(b) plans) if amounts are contributed to or allocated to the person's account for the tax year, or if the person is eligible for the allocation (e.g., 401(k) deferral eligibility).

A person is considered covered by a defined benefit plan if the person meets the minimum age and service requirements within the tax year. The defined benefit plan active-participation rules apply even if the person declined to participate, did not make a required contribution, or did not perform the minimum service required to accrue a benefit.

When the taxpayer is an active participant in a qualified plan, the IRA deduction may be reduced or eliminated depending on marital status and modified adjusted gross income (MAGI). MAGI is AGI with certain items added back, including the IRA contribution. This is necessary because the IRA contribution is an “above the line” deduction taken in arriving at AGI.

For single taxpayers, the phaseout begins with the inflation adjusted applicable dollar amount and is fully phased out once MAGI exceeds the applicable dollar amount for that year by $10,000.

For married taxpayers filing a joint return, the phaseout begins with the inflation-adjusted applicable dollar amount and is fully phased out once MAGI exceeds the applicable dollar amount for that year by $20,000.

Example: In 2016, Molly, a single taxpayer, has AGI of $60,000. She makes an IRA contribution of $5,000; her deduction is $3,000, calculated as follows:

$60,000 AGI + $5,000 IRA contribution = MAGI of $65,000
$65,000 - $61,000 (the applicable dollar amount for 2016) divided by $10,000 = 40%
$5,000 x 40% = $2,000 (the reduction amount)
$5,000 - $2,000 = $3,000 (the deductible amount)

Example: In 2016, Sarah and Ken, married taxpayers, have AGI of $100,000. They make an IRA contribution of $5,000; their deduction is $3,250, calculated as follows:

$100,000 AGI + $5,000 contribution = MAGI of $105,000
$105,000 - $98,000 (the applicable dollar amount for 2016) divided by $20,000 = 35%
$5,000 x 35% = $1,750 (the reduction amount)
$5,000 - $1,750 = $3,250 (the deductible amount)

For married taxpayers filing separately, the applicable dollar amount is $0 and the deduction phaseout is complete once modified AGI reaches $10,000.

For a married taxpayer who is not a plan participant, but whose spouse is covered by a qualified plan, the 2016 phaseout for deducting the IRA contribution begins when MAGI exceeds $184,000 on their joint return. The deduction is lost completely once MAGI reaches $194,000.

Distributions from Traditional IRAs

Distributions from an IRA—whether paid in a lump sum or installments—are taxable under the Section 72 annuity rules. Although taxpayers are free to make withdrawals whenever they want, distributions that occur before age 59½ are subject to tax penalties (unless certain exceptions apply) in addition to the regular income tax. The IRA owner must begin taking distributions in minimum annual amounts at age 70½ or face tax penalties.

Premature Distribution Tax

The premature distribution tax is aimed at taxpayers who withdraw funds before retirement. This rule places a 10% federal tax on the amount of any distributions that occur prior to age 59½, in addition to the regular tax on the distributions. Besides the age 59½ safe harbor, there are other exceptions [IRC Sec. 72(t)] for distributions that:

occur following the disability of the IRA owner (but not a spouse's or child's disability), disability defined for this purpose as the owner's inability to "engage in any substantial gainful activity by reason of a medically determined physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration" [IRC Sec. 72(m)(7)];

are part of a series of substantially equal periodic payments made not less frequently than annually, for the life (or life expectancy) of the IRA owner or for the joint lives (or joint life expectancies) of the IRA owner and his/her designated beneficiary;

are transferred directly or properly rolled over within the 60-day rollover period, so that the distribution is not subject to the regular income tax;

are taken by an unemployed IRA owner to pay health-care premiums and do not exceed the amount paid for medical insurance (IRA owner must have received unemployment compensation for at least 12 weeks);

are taken to pay deductible medical expenses of the IRA owner or a family member and do not exceed the amount deductible under IRC Section 213 (i.e., only those medical expenses paid out-of-pocket and not covered by insurance that exceed 10% of adjusted gross income, or, during 2013-2016, or 7.5% for taxpayers over age 65);

are used within 120 days to pay acquisition costs of the first-time principal residence of the IRA owner, spouse, child, grandchild, or parent or grandparent of the IRA owner or spouse (lifetime maximum of $10,000);

are used to pay qualified higher education expenses (required tuition, books, fees, equipment, and supplies) of the taxpayer, spouse, child, or dependent grandchild of the taxpayer or spouse; or

Remember that if an IRA owner satisfies one of these exceptions, the IRA owner only avoids the 10% penalty on premature distributions, not the regular income tax on the distribution.

With respect to "substantially equal periodic payments," we need to make an important qualification. If an IRA owner has started to take qualifying periodic payments, and later elects to reduce, increase, or halt such payments before age 59½ or within five years of starting, that will trigger the 10% penalty on all payments made before 59½, even if the IRA owner is over 59½ when changing the form of payment.

The age-55 exception, whereby a qualified plan participant age 55 or over who has separated from service may take distributions without the 10% penalty, does not apply to IRA distributions.

Distribution Requirements for Traditional IRAs

If the IRA owner is going to annuitize the payout, distributions may be made as a:

Life Annuity—IRA owner receives monthly payment for life (or life expectancy) with no further payments to anyone after the individual dies.

Joint-and-Survivor Annuity—IRA owner receives reduced payments for life and thereafter payments continue to a designated beneficiary (or joint life beneficiaries).

Period Certain Annuity (a.k.a. fixed-period annuity)—IRA owner (and/or beneficiary) receives payments for a definite period, but not longer than the life expectancy of the IRA owner or joint life expectancies of the owner and the beneficiary.

Roth IRAs

The Roth IRA became available to taxpayers in 1998. The Roth IRA is unique in that the owner may not deduct contributions, but may take qualifying distributions free of federal income tax when certain requirements are met.

Joint filers with modified adjusted gross incomes (MAGI) above $194,000 and single taxpayers with MAGIs above $132,000 cannot contribute to Roth IRAs. Eligibility to contribute begins to phase out when joint Modified AGI reaches $184,000, and when single-filer MAGI reaches $117,000. The annual contribution limit for a Roth IRA is the same as for traditional IRAs, but must be reduced by any contributions made to traditional IRAs for the year. Active participants in an employer-sponsored qualified retirement plan may contribute to a Roth IRA if otherwise eligible without regard to the MAGI phaseout range for active participants contributing to a traditional IRA. Owners may withdraw contributions at any time without taxation or penalty.

The following chart summarizes the annual contribution limits for Roth IRAs, which hinge on the taxpayer's filing status and MAGI level:

*The taxpayer's AGI is determined without regard to any deduction for contributions to a traditional IRA, and without regard to any income resulting from the conversion of a traditional IRA to a Roth IRA. This is a Modified AGI. For a Roth IRA, the contribution limits based on MAGI apply regardless of whether the taxpayer or spouse is an active participant in an employer's qualified retirement plan. The MAGI phase-out range for taxpayers who are married filing separately is zero to $10,000. If such a taxpayer's AGI is more than $10,000, a Roth IRA contribution is not permitted. The applicable dollar limits in the MAGI levels listed above are inflation-indexed, with any increase being rounded to the nearest multiple of $1,000.

**For taxpayers in the middle range whose contribution limit is reduced: multiply $5,500 (or $6,500 if age 50 or over) by a fraction, the numerator being the excess of the taxpayer's MAGI over $184,000 if married filing jointly or $117,000 if single or head of household, and the denominator being $10,000 if married filing jointly or $15,000 if single or head of household. Subtract the result from $5,500 ($6,500 if 50+) to get the maximum contribution by the taxpayer; however, a $200 minimum contribution may be made when the AGI phase-out lowers the contribution limit to less than $200 but more than zero.

Distributions

After the owner has had a Roth IRA for at least five years, the earnings may generally be withdrawn federal income tax free:

following the owner's disability (as defined by the Internal Revenue Code and tax regulations), or

if used for qualifying first-time homebuyer expenses ($10,000 lifetime maximum).

Note: there are two limited exceptions for distributions taken by military reserves called to active duty and public safety employees who separate from service after age 50.

Distributions from all Roth IRAs are subject to an ordering rule, no matter which Roth IRA the distribution is taken from: contributions first, then conversion amounts included in income (on a FIFO basis), then conversion amounts not included in income (on a FIFO basis), and finally earnings. In other words, the nontaxable portion of a person's Roth IRA is exhausted before a distribution is deemed taxable.

The required minimum distribution rules [IRC Sec. 401(a)(9)(A)] that apply to traditional IRAs and qualified retirement plans do not apply to lifetime distributions from Roth IRAs. Thus, distributions need not begin by April 1 of the year following attainment of age 70½. Further, contributions may continue beyond age 70½ if the individual or spouse is still working. Beneficiaries must take minimum distributions after the death of the Roth IRA owner.

Conversions

Owners may convert traditional IRAs into Roth IRAs. The conversion requires a distribution from the traditional IRA that is subject to federal income tax. Note that, in the conversion process, owners under age 59½ are not subject to the 10% tax on a premature distribution from a traditional IRA. However, if the person subsequently takes a distribution from the Roth IRA within five years of the conversion date, then the 10% penalty tax does apply according to IRC §72(t).

There is no AGI limit restricting the conversion of a traditional IRA to a Roth IRA, and there is no prohibition of married taxpayers filing separately from making the conversion.

Click here to see the prior rules.

(1) Combined 2016 contributions to traditional and Roth IRAs cannot exceed $5,500 ($6,500 if age 50 or over).

(2) For single taxpayers, the 2016 AGI phaseout ranges begin at $61,000 (traditional) and $117,000 (Roth).

(3) For single taxpayers, the 2016 AGI phaseout ranges end at $71,000 (traditional) and $132,000 (Roth).

(4) Withdrawals of earnings are not taxable if held for at least 5 years, and if made after attainment of age 59½ or by reason of death, disability, or for a first-time home purchase (maximum: $10,000, lifetime).

(5) Taxes are payable at the time a traditional IRA is converted to a Roth IRA. Contributions can be withdrawn income tax free at any time, but distributions of earnings may be taken tax free from the Roth IRA only if certain requirements are met.

(7) The modified AGI and filing status requirements for converting a traditional IRA to a Roth IRA were eliminated January 1, 2010.

(8) For traditional IRAs, the phaseout range applies to deduction limits for "active participants."

Rollovers from Employer Plans

The IRS allows in-plan Roth conversions without requiring eligibility for distribution. Amounts eligible for conversion are:

A plan must contain provisions allowing for Roth accounts and Roth conversions, and may restrict the types of contributions that are eligible to be converted. Transferred amounts are taxed in the year of the transfer and employees pay the tax with their tax returns for that year. If a participant takes a distribution of the conversion amount within five years of the date of the conversion, the early withdrawal penalty tax (prior to age 59½) will also apply, unless the participant is exempt from the penalty at the time of the distribution.

For prior rollover rules, click here.

Tax-Free Charitable Distributions

The owner of a traditional or Roth IRA is allowed to exclude from income a "qualified charitable distribution" of up to $100,000 per year. This type of distribution is often called an IRA charitable rollover since it is rolled over directly from the IRA to a charitable organization described in IRC Sec. 170(b)(1)(A) [other than an organization described in IRC Sec. 509(a)(3) or a donor advised fund, as described in IRC Sec. 4966(d)(2)]. The distribution qualifies for favorable tax treatment only if made on or after the date the IRA owner attains age 70½. For more information, click here.

myRA Arrangements

The "myRA" is a retirement vehicle targeted to those who lack access to workplace retirement savings arrangements such as 401(k) plans. It is available to anyone with household income below $194,000 (as indexed for 2016)—the income limit for making Roth IRA contributions. (See the table above.)

While myRA is short for "my IRA," it is not an IRA. Rather, it is a hybrid retirement vehicle that conceptually resembles a Roth IRA but is offered through an employer. It is funded with a special kind of savings bond purchased through payroll deduction on an after-tax basis. These bonds are secured and guaranteed against loss, with the same variable-interest-rate return offered by the Government Securities Investment Fund in the federal employees' Thrift Savings Plan.

Contributions are voluntary and automatic, and the myRA owner can withdraw them tax free at any time. Contributions count toward the saver’s tax credit for qualified retirement savings contributions. In keeping with the legislative intent that the myRA be viewed as a "starter" account and not as a means of supplanting traditional savings vehicles, contributions are limited to a span of 30 years or a maximum total of $15,000, whichever comes first. At that point, the owner must transfer the balance to a private sector Roth IRA.

Savers can keep their accounts when they change jobs and can roll the balance into a private-sector retirement account at any time. There are no annual maintenance fees and contributors are not required to report contributions or earnings to the IRS on their tax returns, but taxpayers will receive Form 5498 (IRA Contribution Information) from Comerica Bank, the custodian of all myRA accounts.

Final Treasury regulations authorizing the retirement savings bond were issued on December 12, 2014. The regulations permit the employer to set a minimum amount for the initial contribution and to set limits for additional contributions. However, no safe harbor minimums were announced. The maximum annual contribution to the savings bond is linked to the limit on Roth IRA contributions under IRC §408A.

The Department of Labor has indicated that employer involvement in administering myRAs does not cause such arrangements to constitute a "plan" subject to ERISA provisions. However, should employer contributions be allowed in the future, this guidance may change.

IRA Summary (2016)

This service is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that neither the publisher nor any of its licensees or their distributees intend to, or are engaged in, rendering legal, accounting, or tax advice. If legal or tax advice or other expert assistance is required, the services of a competent professional should be sought.

While the publisher has been diligent in attempting to provide accurate information, the accuracy of the information cannot be guaranteed. Laws and regulations change frequently, and are subject to differing legal interpretations. Accordingly, neither the publisher nor any of its licensees or their distributees shall be liable for any loss or damage caused, or alleged to have been caused, by the use of or reliance upon this service.

Taxpayer's Modified AGI Level* (2016)
Married Filing Jointly	Single or Head of Household	Contribution Limit (2016)
0 to $184,000	0 to $117,000	$5,500 ($6,500 for age 50+)
$184,000 to $194,000	$117,000 to $132,000	reduced**
$194,000+	$132,000+	-0-

	Type of IRA
	Traditional IRA	Contributory Roth	Roth Conversion
Contributions deductible?	Maybe	No	No
Contribution limit	$5,500 (1)	$5,500 (1)	N/A
AGI phaseout range begins—joint return (2)	$98,000 (8)	$184,000	N/A
AGI phaseout range ends—joint return (3)	$118,000 (8)	$194,000	N/A
Tax-deferred earnings?	Yes	Yes	Yes
Withdrawals generally taxable?	Yes	No (4)	No (4, 5)
Home-purchase withdrawals permitted?	Yes ($10,000 lifetime max.) (6)	Yes ($10,000 lifetime max.)	Yes ($10,000 lifetime max.)

	Roth IRA	Traditional IRA
Maximum contribution:
age 49 and under	$5,500*	$5,500*
age 50 and over	$6,500*	$6,500*
Contributions allowed after age 70½?	yes	no
Maximum deduction:
age 49 and under	zero	$5,500**
age 50 and over	zero	$6,500**
Active participant in employer plan?	irrelevant	important
Joint return phaseout range	$184,000-194,000	$98,000-118,000**
Single taxpayer phaseout range	$117,000-132,000	$61,000-71,000**
Tax-deferred earnings?	yes	yes
Income tax-free withdrawals after 5 years?	yes, potentially	no
Withdrawals after age 59½ without 10% penalty?	yes, potentially	yes, potentially
Required minimum distributions after age 70½?	no	yes

Year	Contribution Limit Under Age 50	Contribution Limit Age 50 and Over
2014	$5,500	$6,500
2015	$5,500	$6,500
2016	$5,500	$6,500

Applicable Dollar Amounts
Tax Year	Married Filing Jointly	Unmarried Taxpayers
2014	$96,000	$60,000
2015	$98,000	$61,000
2016	$98,000	$61,000